Correctly predicting a market event eight months in advance is exceedingly difficult. Ted Seides, managing partner at Hidden Brook Investments, did just that back in May, but is unlikely to have celebrated.
Rather than making a bold call that came to pass, Seides conceded defeat in a bet that his former firm, Protégé Partners, had made with Warren Buffett a decade ago. The $1 million wager for charity was that over the following 10 years the average of five funds of hedge funds would outperform a Vanguard S&P 500 tracker.
From the beginning of 2008 to the end of 2016, the hedge funds selected by Protégé returned an annualized 2.2%. Buffett’s index fund produced 7.1% a year. Even the best of Protégé’s quintet generated just 62.8% cumulatively, far behind the S&P’s 85.4%.
‘With eight months remaining, for all intents and purposes, the bet is over,’ Seides acknowledged in May. ‘I lost.’ However, he added ‘My guess is that doubling down on a bet with Warren Buffett for the next 10 years would hold greater-than-even odds of victory. The S&P 500 looks overpriced and has a reasonable chance of disappointing passive investors.’
Buffett confirmed in early October that he would be willing to renew the wager. The S&P 500 ‘will absolutely kill every one of the funds of funds,’ he argued. ‘Passive investment in aggregate is going to beat active investment because of fees.’ Mark Yusko, founder and chief investment officer of Morgan Creek Capital, has expressed interest in taking up the hedge fund side of the bet.
Given developments in the market over the past decade, an intriguing possibility would be to pit the S&P 500 fund not against traditional hedge funds but against a newer alternative – ETFs.
Yusko himself is reportedly exploring the launch of a ‘best ideas’ ETF with AdvisorShares. ‘It’s not a pure hedge fund per se, but it would allow us to bring hedge fund-like strategies to the average investor,’ he explained. He previously ran the Morgan Creek Global Tactical ETF with AdvisorShares, which was liquidated in May this year. It had employed a discretionary multi-asset macro approach, but had lagged its Tactical Allocation peer group over one and three years until its closure.
Contrasting the S&P 500 with such ETFs rather than conventional hedge funds illustrates how Buffett is both right and wrong: right in that the index tends to deliver higher returns, but wrong to argue that this underperformance is to do with fees. Instead, the issue is simply that these hedged strategies are not designed to beat equity markets; if anything, they are destined to trail them because they concentrate on minimizing the downside risk rather than maximizing the upside.
Consider the IQ Hedge Multi-Strategy Tracker ETF (QAI). At $1.1 billion, it is the largest hedge-like ETF. From its inception in March 2009 to the end of September this year, it has returned an annualized 4.1%. The S&P 500, on the other hand, has delivered 15.9%.
This gulf in performance is not because the ETF levies huge fees: its management charge is 0.75%, and underlying costs – it invests in other ETFs, not hedge funds – take its total expense ratio to 0.98%.
The ETF’s investment process is the real source of its muted performance. The fund allocates across asset classes on both a long and a short basis, in a quantitative and rules-based approach that seeks to replicate the risk-adjusted return characteristics of hedged strategies. It therefore has themes such as market neutral, event driven and fixed-income arbitrage.
The fund’s present positions give some idea of how it is likely to perform in the future: it has 25% in the Vanguard Short-Term Bond ETF. In a bull market, such exposure will never beat the S&P 500. In a downturn, though, it should meet its stated objective – low equity correlation. For instance, in 2008 the maximum drawdown in the IQ Hedge Multi-Strategy index was 7.9%; the S&P 500 lost 36% that year and took almost a full year longer to begin recovering.
Less encouraging is one of the other largest and oldest hedge-like ETFs, the SPDR SSGA Multi-Asset Real Return (RLY). Launched in 2012, its aim is ‘to achieve real return consisting of capital appreciation and current income.’ From inception to the end of September it has lost 1.25% a year, despite a relatively modest gross expense ratio of 0.7% and again investing in other ETFs. Instead, it has been dragged down by a large weighting to commodities.
As Seides observed in May, ‘Fees will always matter, but market risk sometimes matters more.’